An Allocation For The Ages

The ongoing evolution of asset allocation.
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RCM Alternatives had an intriguing blog post titled What would you put in a 100-year portfolio? I didn’t take it to be about 100 years literally but more like a combo of being sustainable (not the ESG meaning) and all weather (not necessarily the Bridgewater meaning, but maybe).

Cutting to the chase, the underlying research done by Artemis Investments created the Dragon Portfolio consisting of 24% domestic equity, 18% fixed income, 21% ‘active long volatility,’ 18% trend following and 19% in gold.

If you’re wondering what ‘active long volatility’ is, one example is buying options with an expectation that the volatility of the underlying asset will increase and so you sell at a profit. This doesn’t necessarily require being directionally correct or guessing correctly about the outcome of an event like earning just that volatility will increase which if it does, means the price of the option would also increase. I did a trade like this, albeit unknowingly, in the 1990’s with Yahoo options. I bought some puts a few days before an earning report and they went up in value a lot before the report even though the stock didn’t go down. I ended up selling before the report for a pretty good profit. My guess about a bad earnings report turned out to be correct but the volatility came out of the puts and they dropped in price even though the stock went down. Sell the news played out in the options market. This was a lucky trade, I didn’t really know what I was doing but it taught a great lesson.

Artemis’ research went back 90 years so couldn’t have really included VIX but there are probably ways to harness volatility with VIX options or exchange traded products but those are complex markets and if I had any interest in dabbling, which I don’t, it certainly wouldn’t be with 21% of the portfolio. Of course, you might be able to find a manager who does understand these markets well enough where something larger than 2-3% would make sense.

Quick theory: cryptocurrencies might be a way to introduce active long volatility into a portfolio but not at 21%. I’ve said start at 1% if you have to own any and if it grows into a larger allocation that’s great, but don’t start big.

The allocation to trend following is interesting. A common application of trend following is managed futures which goes long and short individual commodities based on some longer term moving average like 10 month or 200 day (those two are essentially interchangeable). Strict managed futures is useful because it tends to have a negative correlation to equities. That comes in handy for decades like the 2000’s but is likely to struggle badly during sustained uptrends like the 2010’s and the last couple of years.

If you look back at the Artemis asset allocation, what does it kind of look like? I think it looks like a variation of the Permanent Portfolio which allocates 25% each to equities, long bonds, gold and cash (or cash proxies). The track record is great but can’t be repeated because the track record benefitted from interest rates that are no longer available.

In the interests of taking bits of process to build your own process, I like the Dragon’s mix of correlations to deliver a sustainable result. I generally want far more in equities for clients than 24%. Outsourcing the management of volatility is a possibility. I like the idea of tail risk products like client and personal holding TAIL from Cambria which essentially owns a bunch of treasuries and few index puts so in a way it would benefit from the bad kind of volatility without deteriorating at anywhere near the pace of an inverse fund in an uptrend for equities. But 21% is way too high in my opinion. Even 5% might be too high for my liking.

For trend following, I’ve mentioned Standpoint (BLNDX) many times. It is a client a personal holding, it blends together equities and managed futures in a 50/50 mix. Look at the chart, in a little under a year and half, it has had a very boring ride to a 30% gain (per Yahoo Finance). At a 2-3% weighting, maybe I didn’t buy enough but no fund can always be the best. I still own BTAL, a long-short fund that did phenomenally well for a couple of years but has struggled lately. I don’t expect BTAL to be an outperformer in a raging bull market (even though it has done that at times) but for a time after I first bought it, the idea that I should have bought more had merit but having 20% in it, great fund that I think it is, might have been problematic.

BTAL as a long-short fund is more like client and personal holding MERFX than BLNDX and maybe long-short should be an allocation in something like a Permanent Portfolio or a Dragon Portfolio? I’ve allocated that way obviously buy the percentages are smaller than what you’d see elsewhere. It is tough to get away from the reality that equities are the best performing asset out there. Almost anything else you own is to help manage the volatility of equities and likely to underperform equities long term.

I also like the idea of labeling an asset allocation category as inflation. Stocks of course are viewed as a hedge against inflation as are TIPS and gold. Bitcoin proponents talk about BTC being anti-fiat thus also has anti-inflationary attributes. Not sure the science is settled on that, but it could turn out to be so.

We haven’t talked about cash. The numbers behind having a lot of cash these days are bad, the real return is negative—meager interest rates not keeping up with inflation. But cash has optionality and there is value in optionality. How much value depends on the individual, there’s no wrong answer but don’t completely ignore optionality.

Tying this all up, equities would be my largest allocation for people in “normal” circumstances. Can’t say whether that means 50% or 70% or some other number as that depends on the individual. Buying fixed income now is very difficult, are you really going to lend the government money for ten years at 1.6% or to a corporation for that long at 2% or maybe even less? If you can find yield and be comfortable with the risk you’re taking (the higher the yield the more risk there is) then go ahead and buy but that is a difficult proposition these days.

I’m obviously a fan of long-short, would you allocate 10% there? I’m closer to mid-single digits but if you choose well, the risk is more like having a drag on the portfolio not a blowup. Too much into a volatility strategy or a crypto currency could result in a blowup though. Remember the blow ups, as in deathblows, to ETPs that shorted VIX? If you believe in cryptocurrencies as a source of asymmetry, along with the other attributes, then clearly they could blow up. That’s not a prediction, that is a smallish probability that exists which begs for sizing appropriately if at all.

Take inputs from as many places as you want and develop an allocation that makes sense to you and then be willing to allow your allocation to evolve. I’m a believer in crypto and would own it in client accounts if there were any ETFs, the trusts just have too many flaws, which is obviously an evolutionary step as they haven’t existed for very long.